Written by: Kames Capital
Sustainability and ESG (Environmental, Social, and Governance) are the new buzz words in investing but – despite their popularity – they are often poorly understood. For us, the case for sustainable investing is clear, and has been amplified by the current COVID-influenced market environment. What we believe this has shown is that considering sustainability supports long-term investment resilience, the understanding of material risks, and identification of opportunities. The result of this has the potential to be a positive impact, both financially and on society, and this belief is increasingly backed by evidence – companies that do good tend to do well(1).
Sustainability can be thought of as a set of characteristics that allow companies to operate with resilience and longevity: maintaining stability over the long term, meeting the financial needs of the present without reducing the ability of future generations to meet theirs. Fundamentally incorporating sustainability into a company’s strategy encourages it to frame decisions through a long-term lens, instead of just focusing on the next quarter’s results. This becomes increasingly important in times of disruption and rapid change.
On a basic level, sustainability analysis can help identify certain industries and companies whose products or business practices are fundamentally harmful to broader society and which could face competitive headwinds as a result. For example, carbon-intensive industries and companies are particularly exposed to so-called “transition risks” – increased regulation and changing societal expectations as we move toward a low-carbon economy. Again, linking this to the current situation and resultant structural changes, these transitions tend to be sped up, further increasing the potential risks for poorly positioned firms.
Avoiding those that are responding inadequately to ESG risks is a good place to start, but there is more to it than that, in our opinion. We believe businesses whose products, services and practices are driving positive societal impact and helping to solve huge challenges facing the world such as inequality, climate change, or healthcare issues could benefit from structural-demand tailwinds, meaning that we think proactively seeking these businesses out has the potential to be a powerful driver of returns. We believe that many businesses in these areas will continue to see strong demand for their products and services for years to come; helping to develop strong competitive barriers, underpinned by focused leadership and differentiated corporate cultures, loyal customers and suppliers.
To a certain extent, this has played out in the recent market volatility – stocks with positive ESG credentials have tended to outperform. For example, research by BlackRock found that 94% of the sustainable indices in their sample outperformed their non-sustainable parent indices in recent market volatility(2). There are a few reasons we can suggest for this:
- As mentioned above, we see a clear link between sustainability and business resilience. We believe businesses with a long-term mindset are more likely to have thought about and have plans in place to deal with significant disruption. When the business environment rapidly changes and becomes much tougher, as it has done, you quickly find out which companies don’t have this resilience, as they are among the first to tap the debt and equity markets for additional funding, or file for bankruptcy.
- We find that many of the most sustainable companies are relatively young and nimble, often set up to challenge an existing way of doing things with a new solution that makes heavy use of new technologies. This means that, naturally, they are born to adapt and to solve problems, and so have the right culture and survive in the current environment when more traditional competitors using outdated processes and systems are struggling with the pace of change.
Leveraging technology to be capital light is key here. It is much easier to expand your software platform or update your app than it is to reconfigure a production line in a factory or build a new manufacturing plant. This has been reflected in the contrasting fortunes of the tech heavyweights this year compared to the traditional “old industries,” which typically have poor sustainability credentials. Indeed, tech seems to be something of a new “defensive” given the way it performed through the selloff of late February and early March.
We believe all of this was true before COVID-19 struck; it has simply been accelerated by the current environment. Forecasting demand and economic growth over the next couple of quarters is almost impossible at the moment but when you take a long-term view, it is easier to find companies that can provide products and services to solve sustainability challenges that are run in an effective way and that have the potential to be the long-term winners – regardless of how long the current environment prevails or what the shape of the recovery is.
1. Khan, Serafiem & Yoon (2016); Corporate Sustainability: First Evidence on Materiality